The growth stock route: a slow, profitable climb

There are many ways to invest and none is intrinsically better than the others. In the final analysis, the only thing that matters about any share or pooled investment you buy is that it goes up. That said, it makes sense to focus on one method - you are more likely to become relatively expert, and success in investment is largely down to gaining an edge over other investors, however small.

There are many ways to invest and none is intrinsically better than the others. In the final analysis, the only thing that matters about any share or pooled investment you buy is that it goes up. That said, it makes sense to focus on one method - you are more likely to become relatively expert, and success in investment is largely down to gaining an edge over other investors, however small.

Most investment approaches are based on one of two main analytical methods: fundamental and technical. Technical analysis, also known as charting, is growing in popularity, but it still remains a minority interest. Within the more widespread fundamental analysis, which most investors practice, there is a further schism between so-called value and growth.

Actually, the distinction is not that helpful, because all investors are looking for value and none of them is averse to a bit of growth. The most committed growth stock investor is actually doing no more than looking for value within a universe of growth shares. But there are important differences between the approaches and there are good reasons why most long-term investors should concentrate on growth shares themselves or buy into a fund which focuses on this kind of stock.

A growth share is first and foremost a share that can demonstrate excellent profits growth prospects - it can grow its earnings per share at an above-average rate year after year. Although any company can grow by buying another business, it is the distinguishing characteristic of a growth share that it can produce organic growth from within.

The main attraction for investors of this kind of company is that it can go on more or less indefinitely in the right circumstances. One of the best examples of this is Coca-Cola, which floated in 1919 at $40 a share, fell within a year to just $20, but then rose relentlessly not for years but for decades. By the end of the century the $40 share was worth several million dollars.

This kind of growth cannot be found in most value investments which have limited upside. This is because if a share's only attraction is its low price relative to the value of, for example, a company's assets it will lose its appeal as soon as the price rises to match those assets. Once it has done this, there is nowhere else to go.

Another advantage of growth shares follows from this. Because growth shares just go on and on, an investor can buy them and forget them. A famous American investor retired in 1944 with $5,000. She died in 1995 with a $22m fortune, having bought a small number of great growth stocks - companies like Coca-Cola and Schering Plough - and simply run her profits.

A related advantage is that because growth stocks allow you to buy and forget, you or the manager of the fund you buy into crystallise profits much less often, and so avoid paying regular slices of capital gains tax. Effectively, you receive a long-term, interest-free loan from the government.

Once you have decided to focus on buying growth shares, you have to decide which ones to buy. This is where the similarity with value investing comes in, because at any given time a growth share can be cheap or expensive relative to its growth potential.

Buying shares when they are relatively cheap is the key to making money in growth stocks. This is because in the long run the price of a share is umbilically linked to the growth in its profits, but over shorter periods its value can fluctuate wildly around this upward path.

Buying a share when it is under the long-term growth trend and selling when it is above the line is the way to maximise your returns. The objective of the growth share investor is to buy a high level of earnings growth for as low a price as possible. And behind all the mumbo-jumbo of PERs and PEGs and EBITDA, it really is as simple as that.

Or it would be, in a perfect world. In reality earnings growth is a slippery target and just when we think we have found the next Coca-Cola at a bargain price the economy turns down or management messes up or someone else comes along and steals your company's market.

This is why investing in a spread of growth stocks is so important. Diversity eases the inevitable ups and downs of individual shares because in a fund invested in, say, 50 stocks the halving in value of any one stock will reduce the value of the fund as a whole only by one per cent.

This spread also dilutes the impact of a fantastic performer. But for most long-term growth share investors this is a price worth paying for a good night's sleep.

Tom Stevenson is editor of hemscott.net